Introduction: Taxes in Spain for US Retirees
Let’s export the topic of taxes for American retirees in Spain.
The starting point would be the 1990 Tax Treaty here
Article 20 of the model treaty tells us that –
1. Subject to the provisions of Article 21 (Government Service):
(a) pensions and other similar remuneration derived and beneficially owned by a resident of a Contracting State in consideration of past employment shall be taxable only in that State; and
(b) social security benefits paid by a Contracting State to a resident of the other Contracting State or a citizen of the United States may be taxed in the first-mentioned State.
2. Annuities derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State. The term “annuities@ as used in this paragraph means a stated sum paid periodically at stated times during a specific time period, under an obligation to make the payments in return for adequate and full consideration (other than services rendered).
Reference is also made to article 21 – Government Service. The relevant portion would be paragraph 2 and 3 –
2. (a) Any pension paid by, or out of funds created by, a Contracting State or a political subdivision or a local authority thereof to an individual in respect of services rendered to that State or subdivision or authority shall be taxable only in that State.
(b) However, such pension shall be taxable only in the other Contracting State if the individual is a resident of, and a national of, that State.
3. The provisions of Articles 15 (Independent Personal Services), 16 (Dependent Personal Services), 18 (Directors’ Fees), 19 (Artistes and Athletes), and 20 (Pensions, Annuities, Alimony, and Child Support) shall apply to remuneration and pensions in respect of services rendered in connection with a business carried on by a Contracting State or a political subdivision or a local authority thereof
The Protocol and Pension Contributions
Fast forward to 2013, we have a Protocol which amends the aforementioned treaty between the US and the Kingdom of Spain. You can read it here.
In 2019, after several years of delays, the U.S. Senate approved four treaty protocols with Japan, Luxembourg, Switzerland and Spain. Republican Senator Rand Paul of Kentucky had placed a hold on each of these protocols in the Senate Foreign Relations Committee for several years because of objections over concerns about the privacy of taxpayer information.
Generally, all four protocols modernize provisions in the respective tax treaties, conforming them to more recent U.S. bilateral tax treaties as well as U.S. law and international standards. The protocols generally conform to provisions in the 2006 U.S. Model Treaty, which was the most recent U.S. model treaty at the time these protocols were under negotiation.
While the protocols address a number of different provisions of the existing U.S. treaties with these countries, they also have an impact on pension plans and we will briefly examine this impact below.
For instance, the Swiss treaty includes favorable language providing tax exemption in the host country for home country pension contributions, but only for assignments up to five years. The protocol with Switzerland does not alter such treatment or add anything new, such as, for example, U.S. tax relief for a U.S. citizen local hire in Switzerland participating in a Swiss pension plan.
The Swiss protocol however does make a change in the pension area, by expanding the types of pension plans that may qualify for treaty relief. The Swiss-U.S. treaty provides that dividends paid to a pension plan situated in the other country are exempt from tax in the home country, provided the Internal Revenue Service and the Swiss taxing authority (the “competent authorities”) agree that the plan generally corresponds to a pension plan in the other country. Prior to amendment by the protocol, the treaty granted this exemption to certain U.S. plans such as 401(k), 403(b) and 457(b) plans, however, individual retirement accounts were not entitled to the zero rate of tax under the treaty for dividends. The protocol extends this exemption for dividends paid to individual retirement accounts, provided the competent authorities issue new guidance confirming the specific individual plans covered.
Accordingly, a U.S. resident investing in a Swiss company via their U.S. 401(k) plan would not be subject to Swiss withholding at source on any dividends paid, and with a new competent authority agreement this benefit may be extended to IRAs and ROTHs as well. This exemption from source country taxation would not be available if the pension plan controls the company paying the dividend.
In addition, the protocol with Spain added similar language with respect to dividends paid to a pension plan situated in the other country, and specifically identifies IRAs as eligible for relief. Accordingly, dividends paid to IRAs and Roth IRAs may be subject to a zero rate of withholding tax. Thus, for example a U.S. resident receiving a dividend from a Spanish company would be exempt from Spanish tax withholding whether the investment was held in a 401(k) or IRA/Roth IRA (unless such dividends are derived from the carrying on of a business, directly or indirectly, by the pension fund or through an associated enterprise).
The Spanish Protocol also adds a new paragraph to the pension article (Article 20). Here it is – Article X
Article 20 (Pensions, Annuities, Alimony, and Child Support) of the Convention shall be amended by adding a new paragraph:
“5. Where an individual who is a resident of one of the Contracting States is a member or beneficiary of, or participant in, a pension fund that is a resident of the other Contracting State, income earned by the pension fund may be taxed as income of that individual only when, and, subject to the provisions of 16 subparagraph (a) of paragraph 1 of Article 20 (Pensions, Annuities, Alimony and Child Support), to the extent that, it is paid to, or for the benefit of, that individual from the pension fund (and not transferred to another pension fund in that other Contracting State).”
It provides for a resident country tax exemption with respect to the earnings accumulating in a pension fund established in the other country, until such time as a distribution is made from the pension fund. Thus, for example, if a U.S. citizen contributes to a U.S. qualified plan while working in the U.S. and then establishes residence in Spain, the added paragraph prevents Spain from currently taxing the plan’s earnings with respect to that individual. Subsequent distributions from the plan would taxable by the U.S. citizen’s country of residence at the time of the distribution. It should be noted that the treaty does not contain language exempting contributions from tax.
It is interesting that the protocols with Japan and Luxemburg contain no related provisions regarding pensions.
Definition of Pensions in Spain
Before we can answer does Spain tax US pensions, let’s first explore the definition of pensions in Spain as it is not as straight forward as one might think.
There are only a handful of U.S. treaties that include an article addressing cross-border pensions, and even fewer with comprehensive language covering multiple scenarios where coverage might be needed, such as the treaties with Germany, the Netherlands and the United Kingdom.
The aforementioned Protocol was signed January 2013, and entered into force on November 27, 2019, and applies to withholding taxes on amounts paid or credited on or after that date.
The question is: Is IRA considered a pension income, an annuity income or a withdrawal of savings?
To answer this, we need to discuss Spain. Spain has three asset-related filings that you are supposed to do every year. The ETE (which is only for people with more than a certain threshold abroad), the modulo 720 and wealth tax.
The wealth tax and Modulo 720 are filed annually: the 720 is just informational, but with huge penalties, and the wealth tax might actually make you pay something. The 720 is designed to be a superset of the wealth tax, so if you file a 720 and later file wealth tax with smaller numbers, you will probably get a letter from the tax department.
Pension plans do not ORDINARILY have to be declared in the declaration of assets abroad; But what foreign products can be considered pension plans?
The problem arises because many times colloquially we refer to any provision financial product (for old-age retirement …) as a pension plan. But it is important to emphasize what requirements a pension product must have so that according to Spanish regulations, it does not have to be declared in the 720 form, since it is considered a pension plan.
The regulations on pension plans are included in the revised text of the Law on the Regulation of Pension Plans and Funds, Royal Legislative Decree 1/2002.
Article 1. Nature of US pension plans in Spain
Pension plans define the right of the people in whose favor they are constituted to receive income or capital for retirement, survival, widowhood, orphanhood or disability, the obligations to contribute to them and, to the extent permitted by this Law, the rules of constitution and operation of the patrimony that the fulfillment of the rights recognized must be affected.
The plan represents a right of the participant or beneficiary, to receive income or capital, when there is a contingency of retirement, survival, widowhood, orphanhood or disability.
In order for us to consider a foreign financial product as a pension plan and not have to declare it in 720, the following requirements must be met:
1. That the contributions are unavailable until a contingency covered by the plan or pension product occurs.
• The contingencies covered can only be: retirement, survival, widowhood, orphanhood or disability.
• That once the contingency has occurred it has not been redeemed (once it is redeemed, the income or capital redeemed must be declared)
401 (K) plans in the United States are pension plans: they do NOT have to be declared. Nor, the “deductible IRA (Individual Retirement Account).
The British ISA (individual savings account) are not pension plans because they can be rescued in cases not provided for pension plans and therefore whether to declare. The most similar product that we have in Spain are the PIAS, whose benefits are exempt, just like the ISAs.
The British QRPPS Qualifying Recognized Overseas Pension Scheme, is a fund to which the rights of a pension plan can be transferred, designed for the case of UK residents who move abroad. Therefore, it is still considered a pension plan. For the purposes of 720 it is not declared. And for IRPF purposes, it is considered regular income as it is redeemed. The SIPP British Self-invested personal pension. They are pension plans themselves, they do not require to be declared in 720. The Canadian RRSP (Registered Retirement Savings Plan). Contributions are deducted from the tax base and benefits are treated as income. It covers contingencies of retirement, widowhood and orphanhood. It should be treated as a pension plan and not declare it in 720. Once the contingency has happened and the contributions are withdrawn, the income is taxable. The consensus seems to be that Traditional IRA and 401ks qualify under these assumptions (although technically IRAs and 401ks can be redeemed with a tax penalty, this gets glossed over). Roth 401ks would be trickier since they are not taxable when withdrawn. ROTHs are obviously not taxable in the US upon distribution. Therefore, there is a strong argument for them to be declared on foreign wealth declarations. As you can see, these rules are highly nuanced, so working with dual qualified tax teams is a must
Distributions from Private US Pensions by Spain Tax Residents
So, does Spain tax US retirement income?
In Spain, Spanish law obviously applies. For funds within an IRA? When there is a distribution, you are taxed in the USA (ignore ROTHs for now). But in Spain you will pay for the profits within the fund. In other words, you would need to bifurcate the contributions from the return on this capital invested. Not only that, you would only need to match sales (assuming equity positions needed to be liquidated to facilitate withdrawals) and distributions within the present tax year so that only these gains are taxed at the appropriate tax rates in Spain (between 19% and 45%).
So in summary, you would ordinarily still include the IRA distributions (from PRIVATE PENSIONS) as taxable income in Spain. Given that are Spanish income, you may be able to apply any excess foreign tax credits against taxes due to the IRS. So from a tax planning perspective, there may be an opportunity to
1. Offset taxes paid in Spain against what is due in the US
2. But keep in mind that there are generally two (2) different baskets of foreign tax credits and they cannot be mixed.
3. Foreign tax credits are only useful if you have foreign (non US) income which is taxable in the US
4. If a taxpayer only has US source income, there may be an opportunity to take a treaty position on form 8833 to re-categorize US income as foreign income
What do we mean by taking a treaty position? The United States is a party to tax treaties designed to prevent double taxation of the same income by the United States and the treaty country. Certain treaties allow a U.S. citizen an additional credit for part of the tax imposed by the treaty partner on U.S. source income. It is separate from, and in addition to, your foreign tax credit for foreign taxes paid or accrued on foreign source income.
The treaties that provide for this additional credit include those with Australia, Austria, Bangladesh, Belgium, Bulgaria, Canada, Czech Republic, Denmark, Finland, France, Germany, Iceland, Ireland, Israel, Italy, Japan, Luxembourg, Malta, Mexico, the Netherlands, New Zealand, Portugal, Slovak Republic, Slovenia, South Africa, Spain, Sweden, Switzerland, and the United Kingdom.
If a sourcing rule in an applicable income tax treaty treats U.S. source income as foreign source, and you elect to apply the treaty, you can include that income under the category Certain Income Re-sourced By Treaty. Treat the income as foreign source to the extent required in the treaty. You must compute a separate foreign tax credit limitation for any such income for which you claim benefits under a treaty, using a separate Form 1116, Foreign Tax Credit, for each amount of resourced income from a treaty country. See Internal Revenue Code sections 865(h), 904(d)(6), and 904(h)(10) and the regulations under those sections (including Regulation section 1.904-5(m)(7)) for any grouping rules and exceptions.
You may have to report certain information with your return if you claim a foreign tax credit under a treaty provision. For example, if a treaty provision allows you to take a foreign tax credit for a specific tax that is not allowed by the Internal Revenue Code, you must report this information with your return. To report the necessary information, use Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).
If you do not report this information, you may have to pay a penalty of $1,000.
In addition to your regular income tax, you may be liable for the alternative minimum tax. You may be able to claim a foreign tax credit for this tax. However, there are restrictions on how much foreign tax credit taxpayers can apply to the alternative minimum tax. You must prepare separate Forms 1116 to compute the foreign tax credit and foreign tax credit limitation for alternative minimum tax purposes. Refer to Form 6251, Alternative Minimum Tax-Individuals, and its instructions for a discussion of the alternative minimum tax foreign tax credit.
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